The US Bond Market is far Larger than the Stock Market: If Even Part of it Blows, it’ll Dig a Magnificent Crater

“So, if rates rise, we get nervous. If rates fall, we get nervous. If rates stay the same, we get nervous. When don’t we get nervous? Raise the rates already! We are talking an idling .25% not 3.5% where we should be to make saving pay, and borrowing a cautionary endeavor as it should be!”

“Perhaps investors are getting nervous because the price action is so bad,” explained DoubleLine Capital CEO Jeffrey Gundlach on Monday about the selling pressures junk bonds have come under after Fed Chair Janet Yellen’s press conference, which had been, in his words, “a little bit of a debacle.”

He complained that Yellen had thrown uncertainty and confusion over financial markets, as Fed heads “kind of no longer have a framework” to go by.

He’s always talking up his $80-billion book, which is full of bonds. He has a lot to lose when rates rise and bonds decline in value. So he said that raising rates this year would be a “policy mistake.”

It certainly would be for him, having ridden the greatest bond bull market all the way to its peak while extracting a ton of fees along the way.

Bond-fund managers like Gundlach already had a few scares to deal with, including the “Taper Tantrum” in the summer of 2013 in reaction to the Fed’s discussions on tapering QE Infinity out of existence, then the “flash crash” in the Treasury market last October 15, and for the past year, the not-so-flash crash in energy junk bonds.

Folks have reason to be nervous about bonds.

Bonds are supposed to be a conservative investment, safer and more predictable than stocks and a host of other asset classes. But bonds are on edge, and investors can see it. And they can see the sheer magnitude of it.

In 2000, the US stock market was valued at $15 trillion and the US bond market at $17.3 trillion, according to the Wall Street Journal. By this year, US stock market capitalization has jumped 76% to $26.3 trillion. But bond market capitalization has soared 125% to $39.5 trillion.

That increase in the bond market was driven largely by enormous, record-breaking issuance by corporate and government entities.

But there’s even more: an additional $9.6 trillion of US-dollar-denominated bonds issued by corporations and governments outside the US. Just paying interest on this debt is going to be a herculean task where local currencies, as in Brazil, have plunged against the dollar [read… World Is Now “More Exposed than Ever” to Explosive Dollar].

So, $50 trillion of dollar-denominated bonds (not counting other debt, such as loans, and products based on them, such as Collateralized Loan Obligations).

These bonds are now perched precariously on edge, after a three-decade bond bull market that culminated with seven years of interest rate repression and QE which pushed yields of even the riskiest junk to ludicrously low levels and prices into the stratosphere. If even part of the bond market blows, given its magnitude, it’s going to dig a magnificent crater.

Amidst the Fed’s cacophony and flip-flopping about raising rates, Fed heads are coming out and putting a rate hike this year back on the table, thus turning this whole thing into a comic zoo, and it would be truly hilarious, if it weren’t for, among other things, the $50 trillion in bonds….

Higher rates could knock already stressed corporate and municipal borrowers off their feet. But it would come at the worst possible time, now that bonds of all kinds have migrated more and more into bond mutual funds and ETFs. Retail investors have poured $1.5 trillion into these funds since 2007 (compared to $829 billion they poured into stock funds over the same time). Bond funds now own 17% of all corporate bonds, nearly double from just before the Financial Crisis.

A portion of these bonds are junk bonds. In the era of near-zero interest rates, bond-fund managers have bought the riskiest bonds so that their slightly higher yields would infuse some oomph into their funds. Many of these junk bonds are now slated for destruction, with energy junk bonds already there.

But this concentration of ownership by bond funds poses its own issues, including larger price drops during times of stress. The Wall Street Journal:

Domestically, the rise of large bond funds has created new risks. As the funds have grown, so has cross-ownership of the same bonds, increasing the likelihood of contagion if one manager starts selling, the International Monetary Fund says. Regulators worry that many investors may not know what is in their funds. A market downswing could lead to rising redemptions of fund shares, prompting funds to sell assets to raise cash and amplifying selling pressure across the market.

Treasuries might not be spared the selloff either. But in the short term, they might be winners if investors get cold feet with their other instruments of capital destruction. Even a small sell-off, whether in stocks or bonds, sends investors scurrying in search of perceived safety. Even during the mini-swoon today, with the S&P 500 down 1.6% and the Nasdaq down 2% as I’m writing this, Treasuries suddenly look appetizing, prices rise, and yields fall. And for now, the 10-year yield has dropped 8 basis points to 2.12%, despite the Fed rate-hike cacophony.

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If you watch this map (or any of the appropriate variants) over several days, it is clear the winds are just shifted around and sending the moisture away from the US West coast (e.g. Washington, Oregon, California).

Regards,

Cooter

Spencer

Sep 22, 2015 at 4:01 pm

BH, a gallon of diesel/gas and give this dickhead Bullard the book of matches. I am ready for this crap to blow.

Cheers.

CrazyCooter

Sep 22, 2015 at 10:17 pm

I am of the opinion it will be a long crisis. All of “TPTB” are attempting to avert, divert, subvert, revert, and pervert their way out of the correction that is required, so it just drags it out and makes it miserable for all. I kind of expect 10 or 15 years from where we are today until we get a genuine bottom.

No one in leadership wants to rip off the bandaid, they are quite happy with the status quo.

Just get out of debt, live cheap, stay mobile, and get out of the way when hell breaks loose.

Regards,

Cooter

night-train

Sep 23, 2015 at 2:36 am

Cooter, you missed invert, convert, and covert. I am not only staying in cash, I am also hanging on to my old coin collection. They might grade collectable poor, but a silver Mercury dime might buy a box of ammunition or a several cans of Spam.

Regards
NT

Jungle Jim

Sep 22, 2015 at 4:20 pm

Not necessarily. I have a strong sense that we are approaching a Wile E. Coyote moment. Ya know, Wile E. chases the Road Runner off a cliff. Everything is fine until Wile E. remembers that he isn’t a bird. He looks down and sees nothing. He gives us a brave little smile and waves goodbye.

The Fed is Wile E. , but so is the ECB, PBOC, and BOJ. All it is going to take is for one of them to look down. We are all taking part in a confidence game. When the confidence ends, so does the game.

Glen

Sep 27, 2015 at 3:33 pm

Faith sums it up. Just like religion when people start losing their faith all hell breaks loose. This faith based religion called Central banking is losing it’s adherents

Michael

Sep 22, 2015 at 4:13 pm

It has taken years to inflate so its not going to go over night. Sort of like a leaky canoe. No one panics until their feet start getting wet. Grab a nice beverage every night and watch the fun and denial.

cocoabean

Sep 22, 2015 at 6:00 pm

Funny that this bond illiquidity/redemption stuff starts coming up NOW, right after the Fed has just whiffed the ball on rates once again…where were these bemoaning potential bond bears the last 7 years++…?

illumined

Sep 22, 2015 at 6:08 pm

So many long term short sell targets so little cash…….

ERG

Sep 22, 2015 at 7:51 pm

AFAIC, the countdown to QE Infinity began when the Yellen press conference ended. When you’re a hammer, every problem is a nail.

VegasBob

Sep 22, 2015 at 9:55 pm

I’ve watched dealer buy/sell spreads for bonds widen considerably over the past year and a half.

Bonds markets have become highly illiquid because bond dealers don’t want to hold inventory. They remember what happened in 2008 and 2009 and they know it’s coming again, and soon. Whatever dealers are buying on the secondary market is at lowball prices. And those lowball buy prices also apply to whatever top-rated bonds that dealers are willing to hold for a few days or weeks until they can sell them.

Dealers are also asking and getting 2-3 points above third-party valuation prices for sales of high quality bonds. So secondary bond buyers and sellers are now getting hosed on both ends.

Lastly, I also follow a number of closed-end bond funds to gauge the health of the financial markets. Some of the funds I follow were selling at slight premiums to net asset values (NAV) a year ago. These same funds are now selling at 10-12% discounts from NAV. That tells me that market participants are expecting a crash in the near future.

night-train

Sep 23, 2015 at 2:56 am

I think Jungle Jim’s Wylie Coyote analogy was the pre-2008 economy. I call this one the Tinkerbell economy. We must believe as hard as we can to keep Tinkerbell alive.
I think Tinkerbell’s light is fading fast. I also think Janet Yellen is treading water waiting for her Witness Protection Relocation Program paperwork to come through.

NT

Julian the Apostate

Sep 23, 2015 at 10:56 am

Finally won over my son to the contrarian camp and he put some gold away for a rainy day. I see patterns while he sees numbers. I snuck in the back door via my daughter-in-law just texting her some updates from various sources on what’s actually going on in the world. I knew she would get him to look at some of it. Once he began to show interest I started sending him analysis with lots of graphs and charts.
This mess the Fed has made of the very purpose of bonds as a conservative alternative to equities has painted the Fed into a corner. I’m sitting with the rest of you on the Long Porch with my mug of Columbian coffee watching the show. They have been very lucky so far but my gut says it’s crunch time. Or in the words of an old Tragically Hip tune: “How do I explain this to you? How do I put it into words? It’s one thing or another, but it’s neither this or that. Actually it’s a collection of things.” She shouted “That’s it, GET OUT!”

unit472

Sep 23, 2015 at 11:12 am

Reading the comments here and looking at the logic of the situation I don’t think there can be a rate hike. If anything we will see NIRP as the Fed tries to bar the exit doors from the high risk casino they have built.

J P Frogbottom

Sep 23, 2015 at 12:16 pm

It just might be “Too Late” to get rational once again on interest rates. Gov Bonds -Do YOU trust them, or would you prefer the bonds of producing companies?
When “confidence” is missing, you know that magical belief that your ball player will set a record, or that your government will make its DEBT good, or your neighbor will return that $5 he borrowed, then people get a bit more demanding of promises -cynical if you prefer.
With the expansion of DEBT over productive assets we believe DEBT is nearly 50% more important? That’s the message I’m getting, along with the message the borrower would rather not pay a fair return, or perhaps ANY return.
The FED hesitated to keep a long promised rise.
I shall hesitate to lend this “most trusted” borrower anything further. Time for all to think of liquidating debt holdings. Let’s give ’em an EMERGENCY!!

Julian the Apostate

Sep 23, 2015 at 6:50 pm

“Neither a borrower nor a lender be.”
I like it! Catchy. Or “Creditors are a superstitious Sect, great Observers of set Times and Dates.” -Poor Richard